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Chapter 4: Keat Et Al: Managerial Economics, Prof A.K. Waithima

This chapter discusses the concept of elasticity in economics. There are four main types of elasticity discussed: price elasticity of demand, price elasticity of supply, income elasticity of demand, and cross elasticity. Price elasticity of demand measures the responsiveness of demand to changes in price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price. Income elasticity of demand measures the responsiveness of demand to changes in income. Cross elasticity measures the responsiveness of demand for one good to changes in the price of another good. The chapter provides examples of calculating different elasticities and discusses how elasticities influence total revenue and business decision making.

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79 views24 pages

Chapter 4: Keat Et Al: Managerial Economics, Prof A.K. Waithima

This chapter discusses the concept of elasticity in economics. There are four main types of elasticity discussed: price elasticity of demand, price elasticity of supply, income elasticity of demand, and cross elasticity. Price elasticity of demand measures the responsiveness of demand to changes in price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price. Income elasticity of demand measures the responsiveness of demand to changes in income. Cross elasticity measures the responsiveness of demand for one good to changes in the price of another good. The chapter provides examples of calculating different elasticities and discusses how elasticities influence total revenue and business decision making.

Uploaded by

Ivy Bucks Wanjiku
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Chapter 4: Keat et al

Managerial Economics, Prof A.K. Waithima

Elasticity the concept


The responsiveness of one variable to changes in

another
When price rises, what happens to demand?
Demand falls
BUT!
How much does demand fall?

Managerial Economics, Prof A.K. Waithima

Elasticity the concept


If price rises by 10% - what happens to demand?
We know demand will fall

By more than 10%?


By less than 10%?
Elasticity measures the extent to which demand

will change

Managerial Economics, Prof A.K. Waithima

4 basic types used


Price elasticity of demand
Price elasticity of supply

Income elasticity of demand


Cross elasticity

Managerial Economics, Prof A.K. Waithima

Price Elasticity of Demand


The responsiveness of demand to changes in price
Where % change in demand is greater than % change in

price elastic
Where % change in demand is less than % change in
price - inelastic

Managerial Economics, Prof A.K. Waithima

Price Elasticity of Demand cont..


The Formula:
=

% Change in Quantity Demanded


___________________________
% Change in Price

If answer is between 0 and -1: the relationship is inelastic


If the answer is between -1 and infinity: the relationship is elastic

Note: has sign in front of it; because as price rises


demand falls and vice-versa (inverse relationship between
price and demand)

Managerial Economics, Prof A.K. Waithima

Exercise
Consumers of a commodity will buy 20
units at the price of Ksh 11 and 38 units at
the price of Ksh 7 per unit. Determine how
much they will buy at the price of Ksh 18.
Determine the price elasticity of demand

Managerial Economics, Prof A.K. Waithima

Range of price elasticity


Price (Ksh)

= 0 demand is
perfectly price inelastic

The demand curve can be a


range of shapes each of which
is associated with a different
relationship between price and
the quantity demanded.

= demand is perfectly
price elastic

Quantity Demanded

Managerial Economics, Prof A.K. Waithima

Figure 4.5 the Point Price Elasticity of Demand

PX
A (EP = -
6

)
B (EP = 5)

C (EP = -2)

D (EP = -1)

E (EP = -0.5)

F (EP = -0.2)

G (EP = 0)

0
10

20

30

40

50

Managerial Economics, Prof A.K. Waithima

60

QX

Relationship between MR and price elasticity of


demand
=

=
+


= (1 +
)

Note:

1
= (1 + )

Managerial Economics, Prof A.K. Waithima

Elasticity

Price

Total
revenue is of
price
x
The importance
elasticity
quantity
sold. In this
is the information
it
example,
TR
=
Ksh
5 xon
provides on the effect
100,000
=
Ksh
500,000.
total revenue of changes in

price.
This value is represented by
the shaded rectangle.

Ksh 5

Total Revenue

D
100

Quantity Demanded (000s)

Managerial Economics, Prof A.K. Waithima

Elasticity
Price

If the firm decides to


decrease price to (say) Ksh
3, the degree of price
elasticity of the demand
curve would determine the
extent of the increase in
demand and the change
therefore in total revenue.

Ksh 5

Ksh 3

Total Revenue

D
100

140

Quantity Demanded (000s)

Managerial Economics, Prof A.K. Waithima

Elasticity
Price (Ksh)

Producer decides to lower price to attract sales

% Price = -50%

10

% Quantity Demanded = +20%


Ped = -0.4 (Inelastic)
Total Revenue would fall

Not a good move!


D
5 6
Quantity Demanded

Managerial Economics, Prof A.K. Waithima

Elasticity

Price (Ksh)

Producer decides to reduce price to increase sales


% in Price = - 30%
% in Demand = + 300%
Ped = - 10 (Elastic)
Total Revenue rises

10

Good Move!

Quantity Demanded

Managerial Economics, Prof A.K. Waithima

20

Elasticity
If demand is price

If demand is price

elastic:
Increasing price would
reduce TR (% Qd > %
P)
Reducing price would
increase TR
(% Qd > % P)

inelastic:
Increasing price would
increase TR
(% Qd < % P)
Reducing price would
reduce TR (% Qd < %
P)

Managerial Economics, Prof A.K. Waithima

Income Elasticity of Demand


The responsiveness of demand to changes in incomes
Normal Good demand rises as income rises and vice
versa( > 0)
Inferior Good demand falls as income rises and vice
versa( < 0)

Managerial Economics, Prof A.K. Waithima

Exercise
With an income of Ksh 9000, consumers are willing

to buy 44 units of a commodity and 69 units when


the income rises to Ksh 12000. Determine and
comment on the nature of the commodity.

Managerial Economics, Prof A.K. Waithima

Elasticity
For example:
= - 0.6: Good is an inferior good but inelastic a rise in income of

3% would lead to demand falling by 1.8%


= + 0.4: Good is a normal good but inelastic a rise in incomes of
3% would lead to demand rising by 1.2%
= + 1.6: Good is a normal good and elastic a rise in incomes of
3% would lead to demand rising by 4.8%
= - 2.1: Good is an inferior good and elastic a rise in incomes of
3% would lead to a fall in demand of 6.3%

Managerial Economics, Prof A.K. Waithima

Cross elasticity of demand


The responsiveness of demand

of one good to changes in the price of a related


good either
a substitute or a complement
=

Managerial Economics, Prof A.K. Waithima

Exercise
At the price of Ksh 5 for commodity X, the demand for

X is 20 units while the demand for Y is 45. When the


price of X rises to Ksh 12, demand for X decreases to 11
units while demand for Y rises to 51 units. Determine:
A) demand function
B) Cross elasticity of demand
C) comment on the relationship between the 2
commodities

Managerial Economics, Prof A.K. Waithima

Elasticity
Goods which are complements:
Cross Elasticity will have negative sign (inverse
relationship between the two)
Goods which are substitutes:
Cross Elasticity will have a positive sign (positive
relationship between the two)

Managerial Economics, Prof A.K. Waithima

Elasticity
Price Elasticity of Supply:
The responsiveness of supply to changes

in price
If Pes is inelastic - it will be difficult for suppliers to
react swiftly to changes in price
If Pes is elastic supply can react quickly to changes
in price
Pes =

%
Quantity Supplied
____________________
% Price

Managerial Economics, Prof A.K. Waithima

Determinants of Elasticity
Time period the longer the time under consideration the

more elastic a good is likely to be


Number and closeness of substitutes
the greater the number of substitutes,
the more elastic
The proportion of income taken up by the product
the smaller the proportion the more inelastic
Luxury or Necessity - for example,
addictive drugs

Managerial Economics, Prof A.K. Waithima

Importance of Elasticity
Relationship between changes in price and total

revenue
Importance in determining what goods to tax (tax
revenue)
Importance in analysing time lags in production
Influences the behaviour of a firm
Impact of devaluation on imports and exports

Managerial Economics, Prof A.K. Waithima

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